Although pension funds, sovereign wealth funds, endowments and individual savers are all very different in nature, they all share a common feature: their level of wealth will determine how well they achieve their objective. While that level of wealth is dependent on investment returns, focussing too much on those returns may lead to objectives not being achieved. The path those returns take is also a key consideration.
Consider, for example, a sovereign wealth fund that wishes to grow its assets in line with inflation to keep its real spending power stable over the next 10 years in order to pay for an expected project in the future. For simplicity, let’s assume that this is a £1 billion fund with no expected inflows or outflows over the next decade and inflation will be 2% per annum over that period. The target wealth level is therefore £1.22 billion.
Now assume the fund is confident it can achieve a real 2% return over the 10-year term on average, but the pattern of those investment returns cannot actually be forecasted. There is a multitude of different paths those returns can take to achieve that real average return of 2%. Yet, those paths can result in very different outcomes for the fund.
For example, one path might be that returns are poor to begin with. On another returns are strong to be begin with. Although the average returns are the same across both scenarios, the total wealth they each generate is quite different because of the effects of compounding. A scenario where returns are poor to begin with will have less assets to grow once a period of strong returns arrives. The compounding effect is therefore less powerful than it would be for a fund that enjoys strong returns at the start of the period. See figure 1…